As the cryptocurrency space continues to expand, we are witnessing an increasingly severe liquidity crisis in the crypto market.
This dramatic change is having far-reaching consequences, so it’s critical to understand what’s causing the liquidity crunch and its potential impact on the future of the crypto industry.
At the heart of the liquidity crunch are recent challenges associated with the banking settlement layer in the crypto market.
Notably, two key platforms, Silvergate Exchange Network (SEN) and Signature Bank’s Signet, are facing significant challenges affecting the real-time settlement services they provide for the cryptocurrency market.
Since these platforms build bridges between traditional finance and the crypto ecosystem, the struggles they experience have wide-ranging ramifications across the industry.
What exactly is a liquidity crisis?
In case you haven’t already, there is strong evidence that the crypto market is experiencing a liquidity crisis.
Just this year, two well-known market makers, Jane Street and Jump Trading, announced that they would scale back their cryptocurrency trading activities in the United States.
Their decision to reduce trading activity could have serious implications for liquidity. So, why did they make this decision?
In addition to increasing regulatory pressure, I believe existing liquidity barriers are the main reason.
Let’s take a deeper look.
One way to measure liquidity is to look at the depth of an exchange’s order book. An order book is a list of buy and sell orders for a particular asset, and order book depth refers to the number of orders at each price level.
A deep order book means that the market is liquid, while a shallow order book indicates low liquidity.
Recent research from crypto analytics firm Kaiko Data found that major crypto exchanges have seen a significant decrease in order book depth over the past few months.
For example, Bitcoin order book depth on Binance, the world’s largest cryptocurrency exchange, has decreased by more than 50% since September 2022, even before the recent SEC lawsuit. The reduction in order book depth is a clear sign that liquidity in the cryptocurrency market is gradually eroding.
This will have many negative consequences, including more difficulties for investors in buying and selling crypto assets, increased risk of price volatility, and more challenges for businesses in accepting crypto payments.
So, why did all this happen?
The impact of SEN and Signet
At the heart of the matter lies the recent closure of two major cryptocurrency banks, Silvergate and Signature Bank. The two financial institutions played a key role in making the crypto market function smoothly, thanks to their innovative blockchain systems, Silvergate Exchange Network (SEN) and Signet. SEN and Signet changed the way money flows in and out of the crypto ecosystem.
Previously, crypto companies relied on traditional banking systems, such as bank wires or the U.S. Treasury’s Automated Clearing House. These methods are not only costly and slow, but also operate only during banking hours, exposing industry participants to settlement risks.
SEN and Signet networks brought change.
They allow for instant commercial transfers, eliminating the waiting time required for funds to clear.
This drives more efficient use of funds, as market makers do not need to tie up funds on multiple exchanges or wait days for funds to clear. Major exchanges such as Coinbase use these two networks to help their institutional clients efficiently top up and settle accounts.
Problem Overview
Beset by regulatory scrutiny and financial woes, Silvergate Bank has discontinued its SEN platform for transferring funds to cryptocurrency exchanges.
On the other hand, Signature Bank was shut down by New York state regulators and its assets were transferred to a new interim entity, Signature Bridge Bank, operated by the Federal Deposit Insurance Corporation (FDIC). Although Signature Bank’s Signet platform continues to operate, its future remains uncertain, prompting major industry players to seek alternative service providers.
demand analysis
SEN and Signet are essential to the functioning of crypto markets. They facilitate instant settlement and allow market makers to trade with a wide range of counterparties without taking on counterparty or settlement risk.
Market makers no longer need to tie up funds on multiple exchanges or wait for days for funds to be cleared, thereby improving capital efficiency. The absence of these platforms has put pressure on market liquidity.
In traditional finance, entities such as DTCC, CME, and ICE act as clearing house companies, acting as the buyer to every seller and the seller to every buyer, providing solutions for counterparty and settlement risks.
However, the crypto market does not yet have such well-established intermediaries.
Importance of security layers
High TPS blockchains may help solve trading problems, but the reality is more complicated. By leveraging bank settlement layers such as SEN and Signet, market makers can rely on banks to comply with sanctions screening laws issued by OFAC of the U.S. Treasury Department. Without these platforms, market makers will face higher risks of violations and severe penalties.
#BinanceUS to suspend USD deposits and are planning to pause FIAT withdrawal channels as early as June 13 2023
— Chain Debrief (@ChainDebrief) June 9, 2023
A continuously functioning crypto market requires an instant settlement layer similar to a bank to release liquidity. The recent difficulties of SEN and Signet reveal the consequences of losing such critical market infrastructure. For example, the SEC filed a lawsuit against Binance, causing its banking partners to suspend operations of its US platform. Previously, FTX and Binance US also encountered difficulties in establishing banking relationships in the United States.
Disadvantages of Centralized Systems
Traditional bank settlement systems such as Fedwire are not able to meet the special needs of the crypto market. Although Fedwire is reliable and efficient, its operating schedule is not compatible with the 24×7 nature of the cryptocurrency market. Fedwire’s inability to process transactions during weekends and federal holidays could limit the flow of funds in the crypto market, leading to a liquidity crisis.
The liquidity crisis has a profound impact on the entire crypto ecosystem. Market makers are the main drivers of market liquidity, and the ability to provide continuous buy and sell quotes is crucial to ensure the efficient operation of the market.
Looking ahead
Faced with a liquidity crisis, the crypto industry faces severe challenges. Existing blockchain-based real-time payment networks require both parties to hold deposit accounts at the same bank. Therefore, banks entering the field need to attract a large number of cryptocurrency participants to build a useful network. However, the collapse of Silvergate and Signature has shaken the confidence of the banking industry, making insulated networks like Bitcoin more attractive, even though the KBW Nasdaq Bank Index fell 14% after Silvergate announced its closure plan.
📙 The Ultimate Guide to Liquidity 🌊📜 Chapters:I - What is Liquidity & Why Does It Matter?II - The Core Principal Of LiquidityIII - Liquidity & Human EmotionsIV - The Technicals Of Liquidity🔥 V - Time, Price & Liquidity (The X & The Y Axis) pic.twitter.com/pyWuapj75s
— opsec (@opsec_crypto) May 13, 2023
In response to this liquidity crisis, the crypto industry's need for a robust, efficient, and reliable instant settlement system has never been more urgent. The solution may lie in finding new banking partners or developing innovative blockchain-based systems to replicate the capabilities and benefits of SEN and Signet. Although the road ahead is challenging, the industry must act prudently and decisively to restore liquidity and ensure the continued development and stability of the crypto market.
